How bearish is the stock market's low volatility?


A lot of ink has been spilled about the stock market’s low volatility recently. You’ve probably read headlines such as “VIX is extremely low”.
We dislike VIX for 2 reasons:

  1. VIX’s history is very limited. It only goes back to 1990. So historical “studies” based on VIX aren’t very useful.
  2. VIX is not the U.S. stock market’s volatility. VIX is a derivative. It’s calculated using puts and calls. It is not a direct measure of the S&P 500’s volatility.

Hence, we measure the stock market’s volatility differently.

We calculate the S&P 500’s 21 day (1 month) rolling standard deviation. Then we divide that by the S&P, and multiply by 100 to calculate the S&P’s true volatility.

This is a very similar idea to Bollinger Bands, which inserts the stock market’s standard deviations above and below a moving average. Here’s the S&P’s 20 day, 2 standard deviation Bollinger Band right now. Notice how it has been extremely compressed for quite a long time.

By our calculation, it has been 93 trading days since the S&P’s 21-day standard deviation last exceeded 1% of the S&P’s nominal value.
This is the true measure of the stock market’s volatility. Just how “low” is this volatility historically?
Here are all the historical cases in which there were more than 90 consecutive trading days in which the S&P’s standard deviation did not exceed more than 1% of the S&P’s value.

January 14, 1994

This signal came out 2 weeks before the S&P began a “significant correction” on January 31. Our medium-long term model predicted this significant correction. Fortunately, our model does not foresee a significant correction today.

February 8, 1966

This signal came out at the EXACT TOP before the S&P began a 22% “significant correction”. This is what we meant by The U.S. stock market in 2017 is very similar to the late-1960s.

December 1, 1964

This signal came out in the middle of a 4.7% pullback. There was no immediate 6%+ “small correction”. Instead, the S&P rallied for another 5 months before making a 10.9% “small correction” in May 1965.

June 4, 1964

This signal came out at the bottom of a 4.4% pullback. The S&P’s next 6%+ “small correction” began almost 1 year later in May 1965.

Bottom line

Notice the extremely wide range of outcomes. 2 of these cases were immediately followed by significant corrections. The other 2 cases were followed by rallies that lasted for months. This is why we don’t use volatility as an indicator.

When volatility is extremely low, you know that volatility will explode higher. But you don’t know when. You don’t know if volatility will explode higher next week, next month, or in half a year. Volatility is not a timing indicator for the stock market.

This is why we prefer our original study Why a correction is long overdue. Here’s the updated version of that study:
It has been 270 trading days since the last “small correction” (i.e. this “small rally” has lasted 270 trading days). Out of the 79 small rallies since 1962 (excluding the current one), only 3 have lasted longer.

  1. 284 trading days
  2. 297 trading days
  3. 335 trading days

By the end of October, this will be the longest “small rally” in history. So we do expect a 6%+ “small correction” in the next few months. That’s why we’re sitting on 100% cash.
Here’s how we think the next small correction will play out.

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